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The discretionary decision to introduce rules

At the core of Market Monetarists thinking is that monetary policy should be conducted within a clearly rule based framework. However, as Market Monetarists we are facing a dilemma. The rules or rather quasi-rules that is presently being followed by the major central banks in the world are in our view the wrong rules. We are advocating NGDP level targeting, while most of the major central banks in the world are instead inflation targeters.

So we have a problem. We believe strongly that monetary policy should be based on rules rather than on discretion. But to change the wrong rules (inflation targeting) to the right rules (NGDP targeting) you need to make a discretionary decision. There is no way around this, but it is not unproblematic.

The absolute strength of the way inflation targeting – as it has been conducted over the past nearly two decades – has been that monetary policy a large extent has become de-politicised. This undoubtedly has been a major progress compared to the massive politicisation of monetary policy, which used to be so common. And while we might be (very!) frustrated with central bankers these days I think that most Market Monetarists would strongly agree that monetary policy is better conducted by independent central banks than by politicians.

That said, I have also argued that central bank independence certainly should not mean that central banks should not be held accountable. In the absence of a Free Banking system, where central banks are given a monopoly there need to be very strict limits to what central banks can do and if they do not fulfil the tasks given to them under their monopoly then it should have consequences. For example the ECB has clear mandate to secure price stability in the euro zone. I personally think that the ECB has failed to ensure this and serious deflationary threats have been allowed to develop. To be independent does not mean that you can do whatever you want with monetary policy and it does not mean that you should be free of critique.

However, there is a fine line between critique of a central bank (particularly when it is politicians doing it) and threatening the independence of the central banks. However, the best way to ensure central bank independence is that the central bank is given a very clear mandate on monetary policy. However, it should be the right mandate.

Therefore, there is no way around it. I think the right decision both in the euro zone and in the US would be to move to change the mandate of the central banks to a very clearly defined NGDP level target mandate.

However, when you are changing the rules you are also creating a risk that changing rules become the norm and that is a strong argument for maintain rules that might not be 100% optimal (no rule is…). Latest year it was debated whether the Bank of Canada should change it’s flexible inflation targeting regime to a NGDP targeting. It was decided to maintain the inflation targeting regime. I think that was too bad, but I also fully acknowledge that the way the BoC has been operating overall has worked well and unlike the ECB the BoC has understood that ensuring price stability does not mean that you should react to supply shocks. As consequence you can say the BoC’s inflation targeting regime has been NGDP targeting light. The same can be said about the way for example the Polish central bank (NBP) or the Swedish central banks have been conducting monetary policy.

Market Monetarists have to acknowledge that changing the rules comes with costs and the cost is that you risk opening the door of politicising monetary policy in the future. These costs have to be compared to the gains from introducing NGDP level targeting. So while I do think that the BoC, Riksbanken and the NBP seriously should consider moving to NGDP targeting I also acknowledge that as long as these central banks are doing a far better job than the ECB and the Fed there might not be a very urgent need to change the present set-up.

Other cases are much more clear. Take the Russian central bank (CBR) which today is operating a highly unclear and not very rule based regime. Here there would be absolutely not cost of moving to a NGDP targeting regime or a similar regime. I have earlier argued that could the easiest be done with PEP style set-up where a currency basket of currencies and oil prices could be used to target the NGDP level.

Concluding, we must acknowledge that changing the monetary policy set-up involve discretionary decisions. However, we cannot maintain rules that so obviously have failed. We need rules in monetary policy to ensure nominal stability, but when the rules so clearly is creating instability, economic ruin and financial distress there is no way out of taking a discretionary decision to get of the rules and replace them with better rules.

PS While writing this I am hearing George Selgin in my head telling me “Lars, stop this talk about what central banks should do. They will never do the right thing anyway”. I fear George is right…

PPPS It is a public holiday in Denmark today, but I have had a look at the financial markets today. When stock markets drop, commodity prices decline and long-term bond yields drop then it as a very good indication that monetary conditions are getting tighter…I hope central banks around the world realise this…